As many expected, the Federal Reserve raised its benchmark interest rate in June, and the decision came alongside an unexpected tilt in the pace of rate hikes for the remainder of 2018.
After some indecision on how fast was too fast, a majority of policy makers now expect two more rate increases in 2018. The Fed’s path paints a potential forecast of which investors must be cognizant: a macroeconomic environment already conducive to rising rates seems to be putting greater pressure on monetary policy.
Is the inflation puzzle finally coming together?
Inflation has been mysteriously absent despite an ascending economy. Fleeting signs have appeared at times – accompanied like clockwork by market panic – but real, lasting inflation is only now starting to take hold.
The Fed has justified rising rates as a tool to mitigate inflation, which many assumed would climb as the unemployment rate dropped. Yet, with the economy essentially at full employment, inflation has been slow to materialize.
To understand the disconnect, it helps to examine today’s economic transformation. On one hand, goods are cheap and plentiful, spurred by technological innovation and global supply chains, which have driven down costs and pushed production to automated, offshore factories. Companies producing goods are increasing their output with fewer employees, enabling them to side-step inflationary pressures. Technology, however, has less of an impact on many service industries. Because of this dynamic, price inflation for services is rising as the labor market tightens.
While theory holds that inflation should rise when skilled labor is at a premium, the Fed’s preferred inflation measure, the core index for Personal Consumption Expenditures (PCE), has been to move higher before exceeding the Fed’s two percent benchmark in May.
[Related:Hear Portfolio Manager Michael Terwilliger’s audio summary of this Commentary]
Inflation in services shows no signs of slowing, and pockets of demand may also awake goods inflation from its slumber. Inflation in freight-related industries is exceeding historical highs, a trickle-down factor that may cascade through the economy. Demand for freight vehicles has been climbing, a sign of inflation building in today’s evolving supply chain.
Core metrics like PCE and the Consumer Price Index are inching higher, but other indicators continue to show more substantial inflation. The New York Fed’s Underlying Inflation Gauge recently rose to 3.2 percent in April, its highest measure since 2006. Meanwhile, producer prices are accelerating at their fastest pace since 2012.
An expanding federal deficit presents problems
While any uptick in inflation has grabbed headlines and rattled markets, a looming debt problem may prove just as pivotal. No matter the party holding the purse strings, the U.S. government has spent freely for years. As we move into the late stages of recovery, spending has ramped up with the Tax Cuts and Jobs Act piling on some $1.5 trillion to the federal deficit over the next 10 years. Adding to the potential crisis is the Fed’s decision to begin winding down its balance sheet.
The Congressional Budget Office projects a fiscal deficit of 4.6 percent of gross domestic product (GDP) in 2019 compared to the 5-year average of 4.1 percent, and recent IMF data expects the U.S. to be the only country in the G20 with an increasing debt-to-GDP ratio over the next five years.
What makes these numbers so unusual is their timing. Typically, the government spends the economy out of recession, and curtails its habits when unemployment is low. Instead, fiscal expansion continues in a tight labor market, a policy that historically pushes debt out of balance and results in higher inflation.
The fixed-income backdrop continues to crystallize
This backdrop only heightens the headwinds facing traditional fixed income. The two-year Treasury rose 48 basis points in the first five months of 2018 on investors’ expectations for higher rates.
An exploding deficit, the Fed’s balance sheet normalization, and price pressures are converging to create an environment conducive to potential rate hike acceleration.
Investors must continue to assess interest rate risk embedded in their portfolios. Buying bonds as rates rise comes with an opportunity cost of capital. If rates continue to climb, bonds bought today must come down. This very real risk is the exact opposite of what investors want from their fixed-income portfolios.
Instead, investors should examine floating-rate, fixed-income obligations, which are better positioned to perform in today’s market. As rates go up, these loans pay higher interest income, helping reduce interest rate risk.